During this period my investing philosophy has evolved and hopefully for the better. In this post I want to give a brief overview of my philosophy as it stands currently. Of course it will hopefully keep on changing and getting better as I learn more. My outlook towards investing in this period has been shaped mostly by warren buffet and Sanjay Bakshi and other investors of their ilk. I like to invest in companies with a sustainable moat being run by honest and intelligent management whose shares can be acquired at a reasonable price. Before acquiring any company I ask the following questions:
Question 1: does the company have a moat or competitive advantage?
A good return on equity for a sustained period in the past is generally a good indicator of the evidence of a moat. The return should be generated by very low amount of leverage.
The next two questions are more qualitative in nature and most of the time is spent on these two questions. I have realised that investing is almost All art and very little science. I must caveat here that I'm talking here of the investing style which I have decided to practise inspired by people I've already mentioned above. There are of course various other investing styles and these lie on a wide continuum starting from pure science to pure art.
Question 2: is the moat sustainable?
To answer this question I use the porters five forces analysis and that has proved quite helpful to me. I try to identify the most important forces and focus on these to try to understand the origin and sustainability of the moat. I would not go into too many details here but hopefully the construct will become clearer as I talk about the specific investments in the coming posts.
But so far I have realised that the moat of the company would generally fall into one of the following categories. I'm sure this is not an exhaustive list and I will keep on adding to this as I come across other categories.
Category 1: Product moat
Moat derived from the specific quality of the Product the company is selling. Typically the product will have one or all of the following characteristics:
- standardised product
- low cost
- can be sold to a wide set of customers and not focused on a niche customer set
- the product has to be bought multiple times by the customers
- produced on a mass scale and hence lends itself to economies of scale in the manufacturing process
Examples of companies in this category include coca cola, relaxo, page industries (jockey), suprajit engineering, Colgate
Category 2: Process moat
Moat derived from the specific process which the company has developed and perfected over a long period of time to profitably serve a niche set of clients. This category typically has the following characteristics:
- process tailored to a niche set of clients
- process has multiple steps which reinforce each other
- strong focus on the niche set of clients
Examples include dell in the 90s, Shriram transport, gruh finance, etc.
Category 3: conglomerate moat (if there is a good capital allocator at the helm)
Diversification can be good in a very select few cases when there is a good capital allocator running the show. I picked this up from a book which has chronicled what these extraordinary people have accomplished through their capital allocation skills, the book being - the outsiders.
Examples include Berkshire Hathaway, Piramal enterprises, Thomas Cook ( the latter two are very much work in progress and I continue to hold them).
Category 4: high switching cost moat
There are cases where it becomes difficult for the customers to switch to a different company due to cost or time or any other reason. In such cases typically the customer is locked in once acquired and she continues using the service for her lifetime.
Examples include hdfc bank (or any other bank for that matter), AIA engineering, dish TV, etc.
Category 5: network effects moat
This is self explanatory and has been covered at multiple other places. Examples include Facebook, Microsoft, rating agencies, etc. This is a very powerful moat as it possesses what is referred to as lollapalooza effect (please see question 3 below). Even such a strong blow to the integrity and reputation such as the financial crisis of 2008 was not enough to dislodge any of the rating agencies. They continue to stand tall to perpetrate their misdemeanour for one more or maybe many more crises.
Next question is probably the most important of all.
Question 3: is there lollapalooza effect? OR in other words - will the moat become stronger with time?
This one was proposed by Charlie munger when he explained the moat of coca cola. Please read it here. Link- http://mungerisms.blogspot.in/2010/04/charlie-munger-turning-2-million-into-2.html
Notice how many factors including operant conditioning, Pavlovian conditioning, economies of scale, etc. come together and reinforce each other and the sum of the parts is much greater than the parts. This is what Charlie refers to as the lollapalooza effect.
This is the dream of any investor. To correctly identify conditions which will give rise to lollapalooza effects. Because when that happens the moat of the company keeps getting stronger with time. Talking about time, I hope you noticed the time period used by Charlie in the above example - more than a century! Ideally that is the desired time period for me - to identify and acquire companies which I never have to sell. Our work will be done if we are able to identify a handful of such companies (or compounders as they are known) over our lifetime.
Which brings me to another factor of my investing philosophy - concentration, which is again borrowed from others. But it does make a lot of sense for investors of this style. First of all it is difficult to identify these compounders which can also be acquired for a reasonable price. Hence when we do identify them, we would expect to reap the benefits for years to come. And it would be a shame to dilute the results by holding less extraordinary companies in the portfolio.
Another related factor which I should talk about is the management. When I invest in a company which I want to hold onto forever, it becomes imperative that the management of the company should work with integrity. Because over long periods of time it is difficult to sustain success which is built on shaky foundations. Hence I don't have a separate question dealing with the integrity of the management. If the company in question does not have it, I would not look at it to begin with.
Let me end by talking about one final point. What happens to our compounders during a recession or downturn? And again I'm not making it a separate question because some compounders are affected more than others. But we might still want to hold them even if they are adversely affected by a slowdown in demand if their moat is intact. Of course, many times this is the best time to acquire the compounders. However, one thing which has become clear to me is that the companies which fall into Product moat category are least affected by the slowdown. The reason could be that most of them sell products which form a small part of our total budgets and in many cases are essential items such as toothpaste and footwear and we have to keep buying them. These companies usually sell at a premium to other compounders. Other than that I'm not still clear whether one category of moat is stronger than the others.
I will end this post here and will keep on modifying or changing the construct above as I discover and learn more. Happy investing and appreciate and welcome comments and criticisms and suggestions.
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